Technical Analysis

As you’ll see by looking at any stock market chart, stock prices are constantly fluctuating even when they are averaging the same value over time. If the price is trending up or down, that is moving steadily up or down on average, you still see many ups and downs in the short term. Technical analysis is meant to determine the market sentiment of the bulk of traders, which in turn produces these fluctuations by simple supply and demand.

Technical analysis can be quite extensive, and you will find many courses and much information on it. The fact is that no one can predict just where a stock price is going, but technical analysis attempts to improve your odds of getting it right. This is important to understand if you’re interested in trading. If you use technical analysis to discover that conditions are right for a stock price to increase, there is no guarantee it will do so. If technical analysis “says” that the price is going up, what it really means is that there’s, say, a 57% chance that the price will go up, or an 82% chance, or whatever. The more “sure” the prediction from technical analysis, say by having several indications in the same direction, the greater the probability. But in reality, the price will either go up or down, and that’s that.

Sorry for belabouring the point, but so many people find it hard to understand this reality, and it is an important lesson to learn if and when you try trading. You may do technical analysis perfectly, and the price still goes the opposite way to what you expect. This is not an error with your analysis (necessarily), your analysis was not “wrong”, and you don’t need to beat yourself up, wondering what mistake you made (note that you might have done it incorrectly, but I’m assuming here that you didn’t). You have to move on, content that on average you are improving your odds and will therefore turn a profit.

One reason I am so adamant on this point is because I got hung up on it for a while. You see, with an engineering background, you tend to have the feeling that there is an “answer” to every problem, in this case the problem of which stocks to pick. All you have to do is tweak your strategies, accommodating the latest exception, until you get one which has the right combination of factors – not! There is definitely no answer that applies all the time, there are only ways of getting “luckier”, that is improving your win ratio.

Technical analysis, despite the name, can be quite simple. One of the basic ideas is that if a price is going upwards or downwards strongly, then it will tend to keep on going in that direction. This idea seems like commonsense, though there are some that would argue with it. There are quite a number of ways that the stock price data can be manipulated to produce other indications, but nowadays it is simple to apply technical analysis because computers do all the calculations for you, and you simply have to look at the charts. If you want to see some samples of the amount of information available, you can go to one of many websites such as www.stockcharts.com or www.bigcharts.com and play around with their graphing software.

Now although I won’t be repeating a lot of technical analysis information here, you need to understand the basics of how it works and is used. Technical analysis is based on two known sets of data, the price of the shares over time, and the number of shares traded over time. These are simply referred to as price and volume. This information is available for most of the markets that are considered for financial trading, and not just for the share market. Technical analysis in this respect is universal, and the way you can apply it to predict share prices is the same as how you apply it to predict commodity prices, currency prices, or anything else within reason.

As a side note, although it is largely the same it cannot be exactly the same in certain cases. For instance, the currency or Forex market is diverse and spread around the world, and does not take place on any particular trading market. That means that the total number of transactions can’t be readily accounted for, so discovering volume is more problematic. No problem, it just means that there’s more emphasis on technical indicators that are based on price fluctuations. And with futures markets, there is additional information available called “open interest”, which accounts for the number of futures contracts that are open at any one time. This simply means you have a little more information on the futures markets that you do with other markets, so this can be taken account of in the analysis.

With technical analysis, you can base your decision on three different main areas: –

the overall shape of the price chart over time, identified with moving averages and chart patterns

the makeup of each trading day or period, which you can see with bar charts or candlestick charts, and

calculated technical indicators, often plotted underneath the price chart and which are often used when deciding that the stock is “overbought” or “oversold”, corresponding to the price being too high and an expectation of a fall, or too low and likely to increase in value.

Here is an example of a price chart for same company we looked at under fundamental analysis, Home Depot. It is a one-year chart, and is the simplest form, simply plotting the price at the close of each day, which you can see on the right-hand side, against the date, which is given along the bottom. The plotted prices are joined up to give a line chart, and this sort of chart can be used for spotting trends and patterns. You can see that the price went up from just over $50 a year ago to around $80 per share, significant appreciation, and not generally typical of the way shares behave in the stock market.

If you look underneath, there is a separate chart labelled “Volume”, again with the scale on the right, and this shows the number of shares traded each day, in millions. You can see that on three days in the past year around 20 million shares changed hands. Spiking in volume is particularly significant to the technical analyst.

While there is a fair amount of data represented on this chart, for technical analysis we often use a Western bar or candlestick chart, the example of which is shown below for the same time period.

Without going into the detail of how it works, which you can read elsewhere, you simply need to know that the white and blue icons that chart the price show a total of four different price points every day, including the opening and closing prices, and the highest and lowest values at which the share was traded. This amount of information is a great help when doing the price analysis.

Finally, as mentioned above technical analysis uses indicators which are often plotted below the chart. This chart shows the “MACD”, the moving average convergence divergence indicator, which is one of many available, even on the simplest of charting packages. Analysts can form opinions of the market sentiment from the movement of the indicator and the crossing of the line. Once again, this is left for individual study.

Technical analysis is powerful, and well worth study if you’re interested in short term trading, but once again you must realize that what you are doing is increasing in your probability of predicting the markets and making a profit, and it is important to learn to accept that you will have losses as well as gains, even if you do everything right. This is one of the hardest mental exercises that anyone gaining knowledge of trading has to learn.